By Nance Ebert, Contributing Writer
REGION – For many people there is typically some confusion when it comes to retirement savings plans and how best to approach them. It is possible to convert some or all individual Traditional IRAs to a Roth IRA but there are a number of potential tax implications to consider when doing so.
Pre-tax vs. after-tax contributions
A Traditional IRA is a retirement savings plan where an individual makes contributions from pre-tax wages which can then be invested and grow tax deferred until it’s withdrawn upon retirement. Because the contributions are from pre-taxed wages, the current year’s income tax that is owed is reduced.
When you reach the age of age of 59 ½ withdrawals can then be made without a penalty from a Traditional IRA and are taxed as ordinary income at the IRA owner’s current income tax rate. Required minimum distributions (RMDs) from a Traditional IRA begin at the age of 72 and are calculated based on life expectancy tables.
A Roth IRA is an IRA where an individual makes contributions from after-tax wages. There are no current year income tax benefits for these contributions. Like the Traditional IRA, withdrawals can be made penalty-free starting at 59 ½. These withdrawals are tax free, provided the account has been open for five years.
One difference to note between a Traditional IRA and a Roth IRA is that eventually, the contributions and the earnings for a Traditional IRA are taxed. Whereas for a Roth IRA, only the contributions are taxed. The earnings are never taxed. In addition, unlike a Traditional IRA, there are no RMDs for a Roth IRA so the money can be withdrawn in retirement when it is needed and not because it is required.
Have a strategy
Many people think that tax rates will increase in the future so they would be better off paying taxes earlier rather than waiting in the future to pay them. When you convert a Traditional IRA to a Roth IRA you pay income tax on the amount of money being converted. This is then added to any other income you may have in the conversion year and could therefore place you in a higher tax bracket, making your tax bill owed higher than expected. Therefore, many financial advisors recommend individuals consider doing the conversion after they retire and are no longer receiving their salary.
“Having a strategic Roth conversion strategy can potentially save you thousands of dollars in future income taxes,” said financial planner Martin Battock. “And reduce your forced IRA distributions during your retirement years.”
A partial conversion strategy is also recommended by some financial advisors. This is where the conversion from a Traditional IRA to a Roth IRA is done over several years in order to ensure that the added income does not put you in a higher tax bracket. If a partial conversion strategy is used, it is recommended to complete the conversions prior to age 72 so RMDs do not have to be taken into account.
Watch your income if you’re on Medicare
Medicare high income surcharges need to be considered when converting from a Traditional IRA to a Roth IRA. In 2021, the standard premium for Medicare Part B was $148.50 per month. If a Roth conversion increases your income above a certain level, you could end up paying much more than that amount. In 2021, high earners paid up to $505.00 per month for Medicare Part B premiums.
A Roth IRA conversion is a bet that tax rates will rise in the future. At the same time, there are several tax pitfalls that need to be considered when converting from a Traditional IRA to a Roth IRA. It might make sense for you to, over the course of several years, make this conversion. Ideally, you should convert just enough to remain within your tax bracket and not move to one that is higher. A certified financial planner or an accountant can help you figure out what is the best scenario for you and your needs.
Planning for retirement – Traditional IRA versus Roth IRA – Fifty Plus Advocate
When to start collecting Social Security – an important retirement decision (fiftyplusadvocate.com)
Should you buy long-term care insurance? (fiftyplusadvocate.com)